In a bit of synchronicity, it seems that some mainstream commentators are starting to to take interest in a topic we’ve commented on in recent weeks, namely, how the difficulty in getting letters of credit is playing a significant role in the contraction in international trade (see our related post earlier today).

John Dizard in today’s Financial Times provides a useful long-form treatment which we hope will start to get this topic on the official radar screen. There is only one aspect of the story we quibble with. He calls letters of credit “plain vanilla”. That isn’t an accurate characterization.

Now if nothing rates as complex unless it involves very fancy math and lots of market risk, then yes, L/Cs are plain vanilla. But they have a lot of operational complexity. Financial letters of credit are pretty simple, but a second type, which is vital for the conduct of a lot of types of trade, documentary letters of credit, are not.

When an international seller is unsure that he will be paid, and an international buyer worries that he might receive something quite different than what he was promised, a documentary L/C is the answer. The buyer’s bank must release the funds once certain DOCUMENTARY requirements are met, hence the name. Some of them relate to the national tax and customs requirements of the port of origin and port of arrival; there may also be port-specific requirements. And there are a whole host of documentary requirements particular to the goods shipped (third party verification of quantity/weight and grade, in some cases multiple quality validations). So the requirement are in fact very complex: and vary with the port pair and the goods involved, and there may be additional wrinkles depending on buyer stringency.

Any one document being out of order means the shipment will be rejected, even if the shipment itself is in fact exactly what the buyer wanted. You then get into matters of custom: for some ports and goods, the buyer may be willing to waive exact conformity to the documentary requirements; some banks are not flexible; in some ports, it is ill advised. So the business requires a good deal of accumulated knowledge of a rather nerdy kind. That doesn’t fit my definition of plain vanilla.

There’s been some low-bandwidth chatter lately about the plunge in the Baltic Dry Index, which is intended to track the price of shipping dry cargo along key routes. In the sort of “oh . . . wow . . . ” manner passing drivers remark on multiple collisions on the highway, it’s been noted that the BDI is down. A lot.

While the BDI has been dropping for months, the real collapse took place from the week after the Lehman bankruptcy. From a level of 4949 then, the BDI had, by last week, come down to 1149, for a decline over about a month of 76 per cent. This doesn’t represent some piece of high-concept securitised paper meeting its maker in front of a judge; this is the real world of physical assets being employed to do actual work.

I had followed shipping in past years, but had never seen a rate of change like that. So I called friends of mine in that world to get closer to the car wreck.

I had wondered if the BDI was truly representative of real-world values, or if it was oversold in the way some credit default swap indices might be.

Nope. Ships really are that cheap. As one broker told me: “I just chartered a Handymax to go to the US Gulf from India for $1,000 a day. So the BDI really is pretty accurate.” A Handymax vessel would typically displace about 40,000 deadweight tonnes. You would notice it if it dropped anchor near your dock. The cash operating costs are at least $1,500 to $2,000 a day. On top of that, figure another couple of thousand dollars a day for the capital costs.

To put that in Presidential election language, what does that mean for hardworking, middle class, average, families who are sitting around the kitchen table playing by the rules? Why should they care that some Greek or Lebanese is under water, so to speak, on his ship?

How about because what you need to stay middle class and average, or hardworking, is being carried on those ships? Those low charter rates indicate that not much is being shipped, apart from cargoes going from one corporate subsidiary to another, or from one highly creditworthy entity to another.

It all goes back to that Lehman bankruptcy. Among the more serious casualties of that colossal failure of leadership was the letter of credit business. There is nothing more vanilla than the l/c for an international shipment. One bank tells another bank that it will accept the credit risk of an individual importer or exporter. They document that, with forms that have been around forever, clerks and computers shuffle the paper around. A fee is charged and goods are released for shipping, inspection, and delivery. The most boring business in the world. Until it stops.

After Lehman those clerks, and their computers, stopped trusting the clerks and computers at other banks. Treasury secretary Hank Paulson’s ignorant and clumsy attempt to avoid moral hazard and systemic risk resulted in uncounted quantities of goods piling up on loading docks, and customers living off inventories and consuming less.

No, I don’t think the Lehman leadership, or the shareholders who went along with them, deserved to be saved. It was not, however, necessary to sacrifice the worldwide flow of goods and credit to make them an example.

The government and banking leaders might think that those clerks and computers will have been reassured by the business cable channels telling them that things will be fine. Well, it hasn’t happened yet.

Some critical institutions were caught in the middle of this. Wachovia, as I mentioned last week, did a lot of letters of credit for the Latin American trade. Royal Bank of Scotland has huge exposure to shipping. The line people working on trade finance need to be told that it is okay for them to take these risks, that they won’t be laid off if they make one good-faith mistake.

Maybe secretary Paulson could go down to the docks in New Jersey, Norfolk, Long Beach, or Jacksonville to symbolically sign some documents. I know, it’s the unfamiliar real world of production and transportation, but the pain of walking around the Port Newark-Elizabeth Marine Terminal will be over quickly.

The BDI will not recover to its bubble highs, of course, and a lot of marginal ships will need to be scrapped over the next few years. This is normal. Shipping people are bipolar by nature, and now we have to go through the depressive phase.

As for freight rates, they will have to recover to the point where the owners can cover their operating costs. That could take a few months longer than you would think, because the cost of mothballing a ship for that period could be higher than keeping it going at today’s rates.

The Chinese shipyards that have taken on a lot of new orders can expect many of those to be cancelled, if there is any leeway in the contracts. As one ship broker told me: “Values are down by half within the past six months, but nothing is actually being sold right now. The problem isn’t with a single trade route. It’s global.”

If it’s true that the Baltic Dry Index (bulk shipping) fell at least partly due to failing letters of credit, then the same ought to apply to container shipping. After a little search I found the BOX index which is for container freight rates. Rates have been falling since June and are now about 50% down. Since end-September the rate of fall has accelerated, so the letters of credit issue may play a role – or just fears of a collapsing market.The URL is:http://www.hansatreuhand.de/uploads/pics/Box_Index.gif

Yves, a short question that’s a bit off the issue. Is everyone getting news-aversion like me? I find myself less a less willing to look at the commentaries and blogs, let alone the straight Bloomberg news – it’s the same horrible stuff day after day. And today I see the number of comments on your blog is really down, down. How much traffic are you getting, or are we all hiding under the blankets?

There’s a story, the contents of which I can’t remember, is a story about a bet someone made on buying ships below bookvalue and very close to scrap value; it may be a story with a pirate like Buffett or some other wealthy tycoon, but I’m drawing a blank … any help with this fond memory appreciated. I blame the LCH.

In the meantime (FYI): Depreciation is based on cost less the estimated residual salvage value. Salvage, orscrap, value is based upon a vessel’s lightweight tonnage (‘‘lwt’’) multiplied by a scrap rate. We use a scrap rate of $150 per lwt, which we believe is common in the dry bulk shipping industry, to compute each vessel’s salvage value. An increase in the useful life of a dry bulk vessel or in its salvage valuewould have the effect of decreasing the annual depreciation charge and extending it into later periods.A decrease in the useful life of a dry bulk vessel or in its salvage value would have the effect ofincreasing the annual depreciation charge.

Also see: Dismantling to proceedThe four AMERICAN ‘ghost ships’, which have been laid up near Hartlepool for the last five years, are set to be dismantled by Able UK in the coming weeks after they were granted a licence for the work. The US Reserve Fleet vessels arrived at the Teesside Environmental Reclamation and Recycling Centre for dismantling but there followed a long-running battle over environmental concerns which delayed the work. The contract for dismantling a further 13 US Navy reserve ships was lost because of the delays.

‘In 2009 The US Will Be Forced To Selectively Default And Devalue Its Debt’

‘We have seen estimates that next year the US will have to finance a $2 Trillion annual deficit. They may be able to push it forward into the next Administration by the forbearance of the world, but not by much.

It should be obvious to anyone that we are approaching the apogee of the Treasury bubble, with the credit bubble having broken already.

When the Treasury says they are facing unprecedented challenges in financing the US public debt next year that is an understatement.

Once the deleveraging of the markets subsides, the dollar and Treasuries will drop, perhaps with some momentum, as the rest of the world realizes that the US has no choice but to default. This can be resolved in several ways, including continued subsidies from foreign sources in the form of virtual debt forgiveness, devaluation of the dollar, raising of taxes, and higher interest rates on debt.’ snip

A Tokyo-based chartering manager handling aframaxes told Tankerworld that “aframax rates have been slumping, because of crashes in the financial markets.” Average VLCC spot rates on all routes lost some 20 Worldscale points from October 6–10, according to Tankerworld data, “Negative sentiment amongst VLCC owners in the Middle East Gulf [MEG], that had started to permeate due to holidays in the East last week, was reinforced this week by the more general, and spectacular, loss of confidence in the worldwide financial markets,” said Gibson last Friday.

A Singapore-based broker specialising in voyages east of the Suez told Tankerworld last Thursday that crude freight rates were softening also because “charterers are in no rush to fix their November loadings.”

"Britannia Bulk Holdings expects to announce a significant net loss for Q3 " … believes that the expected loss will have resulted from the substantial decreases in dry bulk charter rates that occurred during the period, exacerbated by the co's increase in chartered-in capacity during the same period and its entry into the forward freight agreements ("FFAs") and a bunker fuel hedge… Co is not currently in violation of its financial covenants. Although no such violations currently exist, severe adverse market conditions and the severe financial difficulties currently being experienced by the co (as well as a revaluation of its fleet) have resulted in a very high risk of a future violation of one or more financial covenants in the near term. Co is in discussions with the lenders under the Facility regarding its current severe financial difficulties and the possibility that events of default may occur under the Facility.

Is the trade LC freeze in part collateral damage from money market fund outflows? The MMFs used to purchase banker’s acceptances in volume. The Fed used to rediscount BAs, but that may be ancient history. But since acceptances trade based on the crediworthiness of the accepting bank, the freeze here looks like another aspect of the interbank term money seizure. So I don’t think the article is correct that accepting banks are afraid of making a clerical error on a documentary LC. I suspect the banks are unable to rediscount the LCs they accept.

“Cook therefore believes the prices of all traded oil contracts, including WTI itself could suddenly decline in a way similar to the decline in mortgage backed securities that are highly leveraged to the relatively small amount of bad mortgage debt written over the past few years.

Cook states that the U.S. WTI contracts are linked by strong arbitrage trades to the European Brent/BFOE futures contracts which in turn are priced directly off the spot cash market for shipload quantities of oil in Europe. Thus, he says, virtually all futures prices depend on the European spot market. Unfortunately, this spot market is very thin and thus subject to manipulation which could either be intentional or accidental based simply on speculative greed. Cook claims that $260B of contracts including “structured products” rest on a base of only $4B of actual cash trades. In other words, he suggest that at some point oil could become like tulips were in the 17th century.”

FYI: In 1985, rates for the biggest tankers hovered at an average of $5,000 a day, forcing many shipowners to file for bankruptcy, said James L. Winchester, a shipping analyst with Mabon, Nugent & Company. Banks often resorted to seizing the ships and selling them for scrap value, seeing little prospect of a quick turnaround.

But by last year, rates had reached an average of $16,000 a day, Mr. Winchester said. This year they have declined to $13,000 to $14,000 a day, although he thinks they will rise again soon. At some periods this year, when there was a shortage of capacity in the Middle East, rates reached $25,000 to $30,000 a day.

Yves, this doubting Thomas still refuses to believe that perceptions of counterparty risk within the banking sector can travel so suddenly from the Lehman failure to this banking backwater. I just have the sense management’s attention is directed to the derivatives markets and that these people go into their offices to do the jobs they know and book the voyages they can. Lots of things can get in the way of those transactions. But the fear that your counterparty might not be around when the ship reaches port… That is completely beyond my imagination.

You clearly understand the issue. And if the problem is not just an insignificant one you are right also about the implications.

One way to avoid counter party risks in respect of letters of credit financing global trade is obviously that both importers and exporters have operative accounts with branches of the same international bank like HSBC.

Very interesting stuff- I agree with you “Marco Polo” at 2:50 pm. It just seems there are so many banks, so many ships in route, and the fact that if a supplier and vendor find problems with what they order, receive, and get paid that the market in short order would correct that (fraudulent vendors or customers would soon become known). But it seems thats the case. Roubini keeps saying banks are insolvent – and if your money for your shipment is in a bank, it may not be much, but if its all you got, I could see how they could just freeze transactions.

What does one make of this lovely excerpt from Blackstone’s head honcho?

” “There has been an amazing achievement” by governments,he said. “The world we were looking at three weeks ago wasreally a virtual end-of-the-world scenario in terms of thecollapse of global finance. Now we have much more stable globalfinancial institutions that will work their way back intofunctionality and health.””

When the first post here on this a couple of weeks(?) back came out, it seemed that finally we had a very serious non-finance business problem that was rather more urgent than worrying about Ditech.com, et al. What’s surprising now is that this urgent situation hasn’t already been addressed.

Could it be that folks in the world of finance and regulators and the treasury and fed are too far removed from ordinary real life to recognize what matters in what order of priority?

Do you know anything about large scale commercial real estate construction? If you are the developer, unless you watch the contractor (and this includes big famous names), as in having your people on site, you will easily pay for materials three times over (I have been told this by one of the very biggest developers in NYC who has for at least a decade also done large joint projects outside the metro area, Forbes 400 level. Being big and rich does not protect you from being ripped off. And it was a common occurrence as he rose through the developer food chain).

Now these are people who deal with each other regularly. And it is both the construction company (albeit more around the margin, they do not want to kill the geese that lay the golden eggs) and the guys on the site. Stuff walks off on a regular basis. Construction sites are a beehive of activity and it is impossible to watch everything all the time.

Now when you are talking international shipping, even if the end buyer and end seller are BigCos used to dealing with each other, there are many middlemen (if nothing else, ports are in the hands of the local stevedores) and plenty of opportunities for theft, adulteration, and partial substitution along the way.

In other words, in some areas of commerce, even parties who know each other and deal with each other regularly STILL need to rely on extensive monitoring. Trade is one of those areas, at least for certain types of goods.

I am under the impression that for oil, far more than other types of trade, that buyers and sellers are large, generally highly bankable credits. So the credit stress may be somewhat less than for other types of goods, but you still have the need to verify cargo (there have been famous cases of shipments being accepted and paid for that were a thin layer of oil floating on top of water!) so documentary L/Cs are used here, but I have no idea what % of the time.

MarcoPolo,

Why if banks are refusing to deal with each other on the MOST straightforward short-term type of exposure would they NOT cut back on riskier, more complicated exposures to each other? It is Banking 101 to reduce risky exposures first and most aggressively in bad times.

dengdinxin,

In theory that is correct, but in practice, even big multinationals have taken to concentrating their banking relationships. Smaller fry cannot practically/affordably have multiple major banking relationships. The bank has to see enough profit potential in the entire relationship. otherwise they charge very high fees for discrete services.

The cases of L/Cs I have heard being turned down HAVE involved big international banks, for instance, Paribas refusing to take an L/C from Citi.

A general comment;

A theory on the earlier L/C post today is that enough firms had stockpiled commodities (remember Krugman, that if prices are “too high” you see high inventories), so manufacturers are running down inventories, full impact not seen yet. I got a comment from one reader that his little company had four years’ of industrial metals inventories!

Anon of 5:10 PM,

I am now making above minimum wage, but would still make more an hour cleaning apartments in NYC. In theory, given my traffic levels, if I were to sell enough CPM based ads, I could make a decent living, but the group I am signed up is building its pipeline, and in this environment, that is taking much longer than they anticipated. They are placing ads at the right rate, but way too few.

So anyone who has contacts with suitable advertisers that are placing ads on the Web, please sent them our way. We have excellent demographics.

Yves, I just want to say I appreciate your shedding light on this topic. I am not yet convinced but I look forward to reading more about it. I might try to ask someone I know who works for customs. Maybe he has some feedback on this.

and let me ask you a question right off the bat: let’s say this is all true and the government fixes it, which commodity has the biggest short squeeze potential? I would guess Iron Ore/Steel but it’s just my own simple guess.

This caught my eye just before I read your post. Consumers aren’t maxed out -they’re in a panic (not rational?):

“Consumers have run away in a panic,” he said. “This cycle, all logic would say, will be tougher and deeper because of the nature of the coordinated global consumer fears. It will take longer to get out of.”

I’m not certain that says as much as it appears to. The fall in the BDI and trade in related goods is largely (entirely?) raw materials. Finished good have much higher value AND lower bulk, vastly higher value per tonnage.

The risk we have been implicitly discussing (although I will admit having failed to state it clearly, and thus many readers may have gotten the wrong idea) is a sharp contraction in commodity shipments. Commodities in particular have more fragmented shippers and more risk of being sent less or lower quality items than finished goods (although there are risks there too).

Finished or intermediate goods would seem better suited for an open account arrangement than raw materials. But even then, the article suggests the shift is in part driven by competitive pressure. Someone I know who has lots of clients that buy from China says reject rates are 50%. In a tougher environment, places where L/Cs had been the norm might revert if conditions improve.

And open accounts put all the credit risk on the exporter. In a worsening global credit environment, once exporters are burned a few times by default, you are likely to see increased stringency in credit extension by open account users.

Yves, in your earlier L/C post, you mentioned that currently despite the trade disruption, companies can still get their resources from inventory.

I think that is correct. But then I wonder if that is the case shouldn’t the commodity price (either spot or near-term future contracts) have gotten little bounce unless we assume that the inventory levels were and are “extremely” high?

Maybe the comment from the reader that his company has 4 years of metal inventories shows how excessive inventory building was…

But the, if you have 4 years of inventory, the one-month-or-so trade disruption has barely scratched your inventory level and inventory “rebuilding” might not happen even when trades resume.

Dizard: “low bandwidth chatter.” Heyyy, the collective we here assembled resemble that remark too closely. I prefer ‘peripheral elucidational argumentation,’ but press is press. ‘Cept it _would_ be civil of JD to get the words ‘Yves Smith’ somewhere in his remarks, but still.

And Yves, that is a good clarification on the BDI contraction suggesting that the bulk of the L/C problem is in raw goods, principally commodities. That puts a different complexion on this beast under an immobile blanket.

“Fast declining commodity prices for oil, iron ore and agricultural products, are causing some Asian banks to reject documents under import letters of credit as their buyer would prefer not to pay the higher price contracted earlier,” says Amita Jhangiani, managing director and Asia-Pacific regional trade head at Citi in Hong Kong.”